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THE OBJECTIVE IN CORPORATE FINANCE “If you don’t know where you are going, it does’nt maCer how you get there”
Aswath Damodaran 2
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First Principles
Aswath Damodaran
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The Classical Viewpoint
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¨ Van Horne: "In this book, we assume that the objecKve of the firm is to maximize its value to its stockholders"
¨ Brealey & Myers: "Success is usually judged by value: Shareholders are made beCer off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value."
¨ Copeland & Weston: The most important theme is that the objecKve of the firm is to maximize the wealth of its stockholders."
¨ Brigham and Gapenski: Throughout this book we operate on the assumpKon that the management's primary goal is stockholder wealth maximizaKon which translates into maximizing the price of the common stock.
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The ObjecKve in Decision Making
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¨ In tradiKonal corporate finance, the objecKve in decision making is to maximize the value of the firm.
¨ A narrower objecKve is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objecKve is to maximize the stock price.
Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible
Residual Claim on cash flowsSignificant Role in managementPerpetual Lives
Growth Assets
Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and
short-lived(working capital) assets
Expected Value that will be created by future investments
Maximize firm value
Maximize equity value Maximize market
estimate of equity value
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Maximizing Stock Prices is too “narrow” an objecKve: A preliminary response
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¨ Maximizing stock price is not incompaKble with meeKng employee needs/objecKves. In parKcular: ¤ -‐ Employees are o\en stockholders in many firms ¤ -‐ Firms that maximize stock price generally are profitable firms that can afford to treat employees well.
¨ Maximizing stock price does not mean that customers are not criKcal to success. In most businesses, keeping customers happy is the route to stock price maximizaKon.
¨ Maximizing stock price does not imply that a company has to be a social outlaw.
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Why tradiKonal corporate financial theory focuses on maximizing stockholder wealth.
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¨ Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently).
¨ If investors are raKonal (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.
¨ The objecKve of stock price performance provides some very elegant theory on: ¤ AllocaKng resources across scarce uses (which investments to take and which ones to reject)
¤ how to finance these investments ¤ how much to pay in dividends
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The Classical ObjecKve FuncKon
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STOCKHOLDERS
Maximize stockholder wealth
Hire & fire managers - Board - Annual Meeting
BONDHOLDERS/ LENDERS
Lend Money
Protect bondholder Interests
FINANCIAL MARKETS
SOCIETY Managers
Reveal information honestly and on time
Markets are efficient and assess effect on value
No Social Costs
All costs can be traced to firm
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What can go wrong?
Aswath Damodaran
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STOCKHOLDERS
Managers put their interests above stockholders
Have little control over managers
BONDHOLDERS Lend Money
Bondholders can get ripped off
FINANCIAL MARKETS
SOCIETY Managers
Delay bad news or provide misleading information
Markets make mistakes and can over react
Significant Social Costs
Some costs cannot be traced to firm
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I. Stockholder Interests vs. Management Interests
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¨ In theory: The stockholders have significant control over management. The two mechanisms for disciplining management are the annual meeKng and the board of directors. Specifically, we assume that ¤ Stockholders who are dissaKsfied with managers can not only express their disapproval at the annual meeKng, but can use their voKng power at the meeKng to keep managers in check.
¤ The board of directors plays its true role of represenKng stockholders and acKng as a check on management.
¨ In PracKce: Neither mechanism is as effecKve in disciplining management as theory posits.
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The Annual MeeKng as a disciplinary venue
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¨ The power of stockholders to act at annual meeKngs is diluted by three factors ¤ Most small stockholders do not go to meeKngs because the cost of going to the meeKng exceeds the value of their holdings.
¤ Incumbent management starts off with a clear advantage when it comes to the exercise of proxies. Proxies that are not voted becomes votes for incumbent management.
¤ For large stockholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet.
¨ Annual meeKngs are also Kghtly scripted and controlled events, making it difficult for outsiders and rebels to bring up issues that are not to the management’s liking.
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And insKtuKonal investors go along with incumbent managers…
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Board of Directors as a disciplinary mechanism
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¨ In 2010, the median board member at a Fortune 500 company was paid $212,512, with 54% coming in stock and the remaining 46% in cash. If a board member is a non-‐execuKve chair, he or she receives about $150,000 more in compensaKon.
¨ A board member works, on average, about 227.5 hours a year (and that is being generous), or 4.4 hours a week, according to the NaKonal Associate of Corporate Directors. Of this, about 24 hours a year are for board meeKngs.
¨ Many directors serve on three or more boards, and some are full Kme chief execuKves of other companies.
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The CEO o\en hand-‐picks directors..
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¨ A 1992 survey by Korn/Ferry revealed that 74% of companies relied on recommendaKons from the CEO to come up with new directors; Only 16% used an outside search firm. While that number has changed in recent years, CEOs sKll determine who sits on their boards. While more companies have outsiders involved in picking directors now, CEOs sKll exercise significant influence over the process.
¨ Directors o\en hold only token stakes in their companies. The Korn/Ferry survey found that 5% of all directors in 1992 owned less than five shares in their firms. Most directors in companies today sKll receive more compensaKon as directors than they gain from their stockholdings. While share ownership is up among directors today, they usually get these shares from the firm (rather than buy them).
¨ Many directors are themselves CEOs of other firms. Worse sKll, there are cases where CEOs sit on each other’s boards.
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Directors lack the experKse (and the willingness) to ask the necessary tough quesKons..
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¨ In most boards, the CEO conKnues to be the chair. Not surprisingly, the CEO sets the agenda, chairs the meeKng and controls the informaKon provided to directors.
¨ The search for consensus overwhelms any aCempts at confrontaKon.
¨ Studies of social psychology have noted that loyalty is hardwired into human behavior. While this loyalty is an important tool in building up organizaKons, it can also lead people to suppress internal ethical standards if they conflict with loyalty to an authority figure. In a board meeKng, the CEO generally becomes the authority figure.
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Who’s on Board? The Disney Experience -‐ 1997
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The Calpers Tests for Independent Boards
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¨ Calpers, the California Employees Pension fund, suggested three tests in 1997 of an independent board ¤ Are a majority of the directors outside directors? ¤ Is the chairman of the board independent of the company (and not the CEO of the company)?
¤ Are the compensaKon and audit commiCees composed enKrely of outsiders?
¨ Disney was the only S&P 500 company to fail all three tests.
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Business Week piles on… The Worst Boards in 1997..
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ApplicaKon Test: Who’s on board?
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¨ Look at the board of directors for your firm. ¤ How many of the directors are inside directors (Employees of the firm, ex-‐managers)?
¤ Is there any informaKon on how independent the directors in the firm are from the managers?
¨ Are there any external measures of the quality of corporate governance of your firm? ¤ Yahoo! Finance now reports on a corporate governance score for firms, where it ranks firms against the rest of the market and against their sectors.
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So, what next? When the cat is idle, the mice will play ....
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¨ When managers do not fear stockholders, they will o\en put their interests over stockholder interests ¤ Greenmail: The (managers of ) target of a hosKle takeover buy out the
potenKal acquirer's exisKng stake, at a price much greater than the price paid by the raider, in return for the signing of a 'standsKll' agreement.
¤ Golden Parachutes: Provisions in employment contracts, that allows for the payment of a lump-‐sum or cash flows over a period, if managers covered by these contracts lose their jobs in a takeover.
¤ Poison Pills: A security, the rights or cashflows on which are triggered by an outside event, generally a hosKle takeover, is called a poison pill.
¤ Shark Repellents: AnK-‐takeover amendments are also aimed at dissuading hosKle takeovers, but differ on one very important count. They require the assent of stockholders to be insKtuted.
¤ Overpaying on takeovers: AcquisiKons o\en are driven by management interests rather than stockholder interests.
No stockholder approval needed…
.. Stockholder Approval needed
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Overpaying on takeovers
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¨ The quickest and perhaps the most decisive way to impoverish stockholders is to overpay on a takeover.
¨ The stockholders in acquiring firms do not seem to share the enthusiasm of the managers in these firms. Stock prices of bidding firms decline on the takeover announcements a significant proporKon of the Kme.
¨ Many mergers do not work, as evidenced by a number of measures. ¤ The profitability of merged firms relaKve to their peer groups, does not increase significantly a\er mergers.
¤ An even more damning indictment is that a large number of mergers are reversed within a few years, which is a clear admission that the acquisiKons did not work.
A case study in value destrucKon: Eastman Kodak & Sterling Drugs
Kodak enters bidding war ¨ In late 1987, Eastman Kodak
entered into a bidding war with Hoffman La Roche for Sterling Drugs, a pharmaceuKcal company.
¨ The bidding war started with Sterling Drugs trading at about $40/share.
¨ At $72/share, Hoffman dropped out of the bidding war, but Kodak kept bidding.
¨ At $89.50/share, Kodak won and claimed potenKal synergies explained the premium.
Kodak wins!!!!
!
23
Earnings and Revenues at Sterling Drugs
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Sterling Drug under Eastman Kodak: Where is the synergy?
0 500
1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000
1988 1989 1990 1991 1992
Revenue Operating Earnings
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Kodak Says Drug Unit Is Not for Sale … but…
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¨ An arKcle in the NY Times in August of 1993 suggested that Kodak was eager to shed its drug unit. ¤ In response, Eastman Kodak officials say they have no plans to sell Kodak’s Sterling Winthrop
drug unit. ¤ Louis Maus, Chairman of Sterling Winthrop, dismissed the rumors as “massive speculaKon,
which flies in the face of the stated intent of Kodak that it is commiCed to be in the health business.”
¨ A few months later…Taking a stride out of the drug business, Eastman Kodak said that the Sanofi Group, a French pharmaceuKcal company, agreed to buy the prescripKon drug business of Sterling Winthrop for $1.68 billion. ¤ Shares of Eastman Kodak rose 75 cents yesterday, closing at $47.50 on the New York Stock
Exchange. ¤ Samuel D. Isaly an analyst , said the announcement was “very good for Sanofi and very good
for Kodak.” ¤ “When the divesKtures are complete, Kodak will be enKrely focused on imaging,” said George
M. C. Fisher, the company's chief execuKve. ¤ The rest of the Sterling Winthrop was sold to Smithkline for $2.9 billion.
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The connecKon to corporate governance: HP buys Autonomy… and explains the premium
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A year later… HP admits a mistake…and explains it…
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ApplicaKon Test: Who owns/runs your firm?
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¨ Look at: Bloomberg printout HDS for your firm ¨ Who are the top stockholders in your firm? ¨ What are the potenKal conflicts of interests that you see
emerging from this stockholding structure?
Control of the firm
Outside stockholders- Size of holding- Active or Passive?- Short or Long term?
Inside stockholders% of stock heldVoting and non-voting sharesControl structure
Managers- Length of tenure- Links to insiders
Government
Employees Lenders
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Case 1: Splintering of Stockholders Disney’s top stockholders in 2003
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Case 2: VoKng versus Non-‐voKng Shares: Aracruz
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¨ Aracruz Cellulose, like most Brazilian companies, had mulKple classes of shares. ¤ The common shares had all of the voKng rights and were held by incumbent management, lenders to the company and the Brazilian government.
¤ Outside investors held the non-‐voKng shares, which were called preferred shares, and had no say in the elecKon of the board of directors. At the end of 2002,
¨ Aracruz was managed by a board of seven directors, composed primarily of representaKves of those who own the common (voKng) shares, and an execuKve board, composed of three managers of the company.
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Case 3: Cross and Pyramid Holdings Tata Chemical’s top stockholders in 2008
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Things change.. Disney’s top stockholders in 2009
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II. Stockholders' objecKves vs. Bondholders' objecKves
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¨ In theory: there is no conflict of interests between stockholders and bondholders.
¨ In pracKce: Stockholder and bondholders have different objecKves. Bondholders are concerned most about safety and ensuring that they get paid their claims. Stockholders are more likely to think about upside potenKal
33
Examples of the conflict..
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¨ Increasing dividends significantly: When firms pay cash out as dividends, lenders to the firm are hurt and stockholders may be helped. This is because the firm becomes riskier without the cash.
¨ Taking riskier projects than those agreed to at the outset: Lenders base interest rates on their percepKons of how risky a firm’s investments are. If stockholders then take on riskier investments, lenders will be hurt.
¨ Borrowing more on the same assets: If lenders do not protect themselves, a firm can borrow more money and make all exisKng lenders worse off.
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An Extreme Example: Unprotected Lenders?
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III. Firms and Financial Markets
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¨ In theory: Financial markets are efficient. Managers convey informaKon honestly and and in a Kmely manner to financial markets, and financial markets make reasoned judgments of the effects of this informaKon on 'true value'. As a consequence-‐ ¤ A company that invests in good long term projects will be rewarded.
¤ Short term accounKng gimmicks will not lead to increases in market value.
¤ Stock price performance is a good measure of company performance.
¨ In pracKce: There are some holes in the 'Efficient Markets' assumpKon.
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Managers control the release of informaKon to the general public
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¨ InformaKon (especially negaKve) is someKmes suppressed or delayed by managers seeking a beCer Kme to release it.
¨ In some cases, firms release intenKonally misleading informaKon about their current condiKons and future prospects to financial markets.
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Evidence that managers delay bad news?
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DO MANAGERS DELAY BAD NEWS?: EPS and DPS Changes- byWeekday
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
Monday Tuesday Wednesday Thursday F r i d a y
% Chg(EPS) % Chg(DPS)
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Some criKques of market efficiency..
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Investors are irraKonal and prices o\en move for not reason at all. As a consequence, prices are much more volaKle than jusKfied by the underlying fundamentals. Earnings and dividends are much less volaKle than stock prices. ¨ Investors overreact to news, both good and bad. ¨ Financial markets are manipulated by insiders; Prices do not have any relaKonship to value.
¨ Investors are short-‐sighted, and do not consider the long-‐term implicaKons of acKons taken by the firm
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Are Markets Short term?
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¨ Focusing on market prices will lead companies towards short term decisions at the expense of long term value. a. I agree with the statement b. I do not agree with this statement
¨ Allowing managers to make decisions without having to worry about the effect on market prices will lead to beCer long term decisions. a. I agree with this statement b. I do not agree with this statement
¨ Neither managers nor markets are trustworthy. RegulaKons/laws should be wriCen that force firms to make long term decisions. a. I agree with this statement b. I do not agree with this statement
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Are Markets short term? Some evidence that they are not..
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¨ There are hundreds of start-‐up and small firms, with no earnings expected in the near future, that raise money on financial markets. Why would a myopic market that cares only about short term earnings aCach high prices to these firms?
¨ If the evidence suggests anything, it is that markets do not value current earnings and cashflows enough and value future earnings and cashflows too much. A\er all, studies suggest that low PE stocks are under priced relaKve to high PE stocks
¨ The market response to research and development and investment expenditures is generally posiKve.
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If markets are so short term, why do they react to big investments (that potenKally lower short term earnings) so posiKvely?
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But what about market crises?
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¨ Many criKcs of markets point to market bubbles and crises as evidence that markets do not work. For instance, the market turmoil between September and December 2008 is pointed to as backing for the statement that free markets are the source of the problem and not the soluKon.
¨ There are two counter arguments that can be offered: ¤ The events of the last quarter of 2008 illustrate that we are more
dependent on funcKoning, liquid markets, with risk taking investors, than ever before in history. As we saw, no government or other enKty (bank, BuffeC) is big enough to step in and save the day.
¤ The firms that caused the market collapse (banks, investment banks) were among the most regulated businesses in the market place. If anything, their failures can be traced to their aCempts to take advantage of regulatory loopholes (badly designed insurance programs… capital measurements that miss risky assets, especially derivaKves)
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IV. Firms and Society
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¨ In theory: All costs and benefits associated with a firm’s decisions can be traced back to the firm.
¨ In pracKce: Financial decisions can create social costs and benefits. ¤ A social cost or benefit is a cost or benefit that accrues to society as a whole and not to the firm making the decision. n Environmental costs (polluKon, health costs, etc..) n Quality of Life' costs (traffic, housing, safety, etc.)
¤ Examples of social benefits include: n creaKng employment in areas with high unemployment n supporKng development in inner ciKes n creaKng access to goods in areas where such access does not exist
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Social Costs and Benefits are difficult to quanKfy because ..
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¨ They might not be known at the Kme of the decision. In other words, a firm may think that it is delivering a product that enhances society, at the Kme it delivers the product but discover a\erwards that there are very large costs. (Asbestos was a wonderful product, when it was devised, light and easy to work with… It is only a\er decades that the health consequences came to light)
¨ They are ‘person-‐specific’, since different decision makers can look at the same social cost and weight them very differently.
¨ They can be paralyzing if carried to extremes.
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A test of your social consciousness: Put your money where you mouth is…
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¨ Assume that you work for Disney and that you have an opportunity to open a store in an inner-‐city neighborhood. The store is expected to lose about a million dollars a year, but it will create much-‐needed employment in the area, and may help revitalize it.
¨ Would you open the store? ¤ Yes ¤ No
¨ If yes, would you tell your stockholders and let them vote on the issue? ¤ Yes ¤ No
¨ If no, how would you respond to a stockholder query on why you were not living up to your social responsibiliKes?
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So this is what can go wrong...
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STOCKHOLDERS
Managers put their interests above stockholders
Have little control over managers
BONDHOLDERS Lend Money
Bondholders can get ripped off
FINANCIAL MARKETS
SOCIETY Managers
Delay bad news or provide misleading information
Markets make mistakes and can over react
Significant Social Costs
Some costs cannot be traced to firm
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TradiKonal corporate financial theory breaks down when ...
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47
¨ The interests/objecKves of the decision makers in the firm conflict with the interests of stockholders.
¨ Bondholders (Lenders) are not protected against expropriaKon by stockholders.
¨ Financial markets do not operate efficiently, and stock prices do not reflect the underlying value of the firm.
¨ Significant social costs can be created as a by-‐product of stock price maximizaKon.
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When tradiKonal corporate financial theory breaks down, the soluKon is:
Aswath Damodaran
48
¨ To choose a different mechanism for corporate governance, i.e, assign the responsibility for monitoring managers to someone other than stockholders.
¨ To choose a different objecKve for the firm. ¨ To maximize stock price, but reduce the potenKal for conflict and breakdown: ¤ Making managers (decision makers) and employees into stockholders
¤ Protect lenders from expropriaKon ¤ By providing informaKon honestly and promptly to financial markets
¤ Minimize social costs
49
An AlternaKve Corporate Governance System
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49
¨ Germany and Japan developed a different mechanism for corporate governance, based upon corporate cross holdings. ¤ In Germany, the banks form the core of this system. ¤ In Japan, it is the keiretsus ¤ Other Asian countries have modeled their system a\er Japan, with family
companies forming the core of the new corporate families ¨ At their best, the most efficient firms in the group work at bringing
the less efficient firms up to par. They provide a corporate welfare system that makes for a more stable corporate structure
¨ At their worst, the least efficient and poorly run firms in the group pull down the most efficient and best run firms down. The nature of the cross holdings makes its very difficult for outsiders (including investors in these firms) to figure out how well or badly the group is doing.
50
Choose a Different ObjecKve FuncKon
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¨ Firms can always focus on a different objecKve funcKon. Examples would include ¤ maximizing earnings ¤ maximizing revenues ¤ maximizing firm size ¤ maximizing market share ¤ maximizing EVA
¨ The key thing to remember is that these are intermediate objecKve funcKons. ¤ To the degree that they are correlated with the long term health and value of the company, they work well.
¤ To the degree that they do not, the firm can end up with a disaster
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Maximize Stock Price, subject to ..
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51
¨ The strength of the stock price maximizaKon objecKve funcKon is its internal self correcKon mechanism. Excesses on any of the linkages lead, if unregulated, to counter acKons which reduce or eliminate these excesses
¨ In the context of our discussion, ¤ managers taking advantage of stockholders has led to a much more
acKve market for corporate control. ¤ stockholders taking advantage of bondholders has led to bondholders
protecKng themselves at the Kme of the issue. ¤ firms revealing incorrect or delayed informaKon to markets has led to
markets becoming more “skepKcal” and “puniKve” ¤ firms creaKng social costs has led to more regulaKons, as well as
investor and customer backlashes.
52
The Stockholder Backlash
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52
¨ AcKvist InsKtuKonal investors such as Calpers and the Lens Funds have become much more acKve in monitoring companies that they invest in and demanding changes in the way in which business is done. They have been joined by private equity funds like KKR and Blackstone.
¨ Individuals like Carl Icahn specialize in taking large posiKons in companies which they feel need to change their ways (Blockbuster, Time Warner and Motorola) and push for change
¨ At annual meeKngs, stockholders have taken to expressing their displeasure with incumbent management by voKng against their compensaKon contracts or their board of directors
53
The HosKle AcquisiKon Threat
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¨ The typical target firm in a hosKle takeover has ¤ a return on equity almost 5% lower than its peer group ¤ had a stock that has significantly under performed the peer group over the previous 2 years
¤ has managers who hold liCle or no stock in the firm ¨ In other words, the best defense against a hosKle takeover is to run your firm well and earn good returns for your stockholders
¨ Conversely, when you do not allow hosKle takeovers, this is the firm that you are most likely protecKng (and not a well run or well managed firm)
54
In response, boards are becoming more independent…
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¨ Boards have become smaller over Kme. The median size of a board of directors has decreased from 16 to 20 in the 1970s to between 9 and 11 in 1998. The smaller boards are less unwieldy and more effecKve than the larger boards.
¨ There are fewer insiders on the board. In contrast to the 6 or more insiders that many boards had in the 1970s, only two directors in most boards in 1998 were insiders.
¨ Directors are increasingly compensated with stock and opKons in the company, instead of cash. In 1973, only 4% of directors received compensaKon in the form of stock or opKons, whereas 78% did so in 1998.
¨ More directors are idenKfied and selected by a nominaKng commiCee rather than being chosen by the CEO of the firm. In 1998, 75% of boards had nominaKng commiCees; the comparable staKsKc in 1973 was 2%.
55
Eisner’s concession: Disney’s Board in 2003
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Board Members OccupationReveta Bowers Head of school for the Center for Early Education,John Bryson CEO and Chairman of Con EdisonRoy Disney Head of Disney AnimationMichael Eisner CEO of DisneyJudith Estrin CEO of Packet Design (an internet company)Stanley Gold CEO of Shamrock HoldingsRobert Iger Chief Operating Officer, DisneyMonica Lozano Chief Operation Officer, La Opinion (Spanish newspaper)George Mitchell Chairman of law firm (Verner, Liipfert, et al.)Thomas S. Murphy Ex-CEO, Capital Cities ABCLeo O’Donovan Professor of Theology, Georgetown UniversitySidney Poitier Actor, Writer and DirectorRobert A.M. Stern Senior Partner of Robert A.M. Stern Architects of New YorkAndrea L. Van de Kamp Chairman of Sotheby's West CoastRaymond L. Watson Chairman of Irvine Company (a real estate corporation)Gary L. Wilson Chairman of the board, Northwest Airlines.
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Changes in corporate governance at Disney
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¨ Required at least two execuKve sessions of the board, without the CEO or other members of management present, each year.
¨ Created the posiKon of non-‐management presiding director, and appointed Senator George Mitchell to lead those execuKve sessions and assist in seung the work agenda of the board.
¨ Adopted a new and more rigorous definiKon of director independence. ¨ Required that a substanKal majority of the board be comprised of
directors meeKng the new independence standards. ¨ Provided for a reducKon in commiCee size and the rotaKon of commiCee
and chairmanship assignments among independent directors. ¨ Added new provisions for management succession planning and
evaluaKons of both management and board performance ¨ Provided for enhanced conKnuing educaKon and training for board
members.
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Eisner’s exit… and a new age dawns? Disney’s board in 2008
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What about legislaKon?
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¨ Every corporate scandal creates impetus for a legislaKve response. The scandals at Enron and WorldCom laid the groundwork for Sarbanes-‐Oxley.
¨ You cannot legislate good corporate governance. ¤ The costs of meeKng legal requirements o\en exceed the benefits
¤ Laws always have unintended consequences ¤ In general, laws tend to be blunderbusses that penalize good companies more than they punish the bad companies.
59
Is there a payoff to beCer corporate governance?
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59
¨ In the most comprehensive study of the effect of corporate governance on value, a governance index was created for each of 1500 firms based upon 24 disKnct corporate governance provisions. ¤ Buying stocks that had the strongest investor protecKons while simultaneously
selling shares with the weakest protecKons generated an annual excess return of 8.5%.
¤ Every one point increase in the index towards fewer investor protecKons decreased market value by 8.9% in 1999
¤ Firms that scored high in investor protecKons also had higher profits, higher sales growth and made fewer acquisiKons.
¨ The link between the composiKon of the board of directors and firm value is weak. Smaller boards do tend to be more effecKve.
¨ On a purely anecdotal basis, a common theme at problem companies and is an ineffecKve board that fails to ask tough quesKons of an imperial CEO.
60
The Bondholders’ Defense Against Stockholder Excesses
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¨ More restricKve covenants on investment, financing and dividend policy have been incorporated into both private lending agreements and into bond issues, to prevent future “Nabiscos”.
¨ New types of bonds have been created to explicitly protect bondholders against sudden increases in leverage or other acKons that increase lender risk substanKally. Two examples of such bonds ¤ PuCable Bonds, where the bondholder can put the bond back to the firm
and get face value, if the firm takes acKons that hurt bondholders ¤ RaKngs SensiKve Notes, where the interest rate on the notes adjusts to
that appropriate for the raKng of the firm ¨ More hybrid bonds (with an equity component, usually in the form
of a conversion opKon or warrant) have been used. This allows bondholders to become equity investors, if they feel it is in their best interests to do so.
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The Financial Market Response
Aswath Damodaran
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¨ While analysts are more likely sKll to issue buy rather than sell recommendaKons, the payoff to uncovering negaKve news about a firm is large enough that such news is eagerly sought and quickly revealed (at least to a limited group of investors).
¨ As investor access to informaKon improves, it is becoming much more difficult for firms to control when and how informaKon gets out to markets.
¨ As opKon trading has become more common, it has become much easier to trade on bad news. In the process, it is revealed to the rest of the market.
¨ When firms mislead markets, the punishment is not only quick but it is savage.
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The Societal Response
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¨ If firms consistently flout societal norms and create large social costs, the governmental response (especially in a democracy) is for laws and regulaKons to be passed against such behavior.
¨ For firms catering to a more socially conscious clientele, the failure to meet societal norms (even if it is legal) can lead to loss of business and value.
¨ Finally, investors may choose not to invest in stocks of firms that they view as socially irresponsible.
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The Counter ReacKon
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STOCKHOLDERS
Managers of poorly run firms are put on notice.
1. More activist investors 2. Hostile takeovers
BONDHOLDERS Protect themselves
1. Covenants 2. New Types
FINANCIAL MARKETS
SOCIETY Managers
Firms are punished for misleading markets
Investors and analysts become more skeptical
Corporate Good Citizen Constraints
1. More laws 2. Investor/Customer Backlash
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So what do you think?
Aswath Damodaran
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¨ At this point in Kme, the following statement best describes where I stand in terms of the right objecKve funcKon for decision making in a business ¤ Maximize stock price, with no constraints ¤ Maximize stock price, with constraints on being a good social ciKzen. ¤ Maximize stockholder wealth, with good ciKzen constraints, and hope/
pray that the market catches up with you. ¤ Maximize profits or profitability ¤ Maximize earnings growth ¤ Maximize market share ¤ Maximize revenues ¤ Maximize social good ¤ None of the above
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The Modified ObjecKve FuncKon
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¨ For publicly traded firms in reasonably efficient markets, where bondholders (lenders) are protected: ¤ Maximize Stock Price: This will also maximize firm value
¨ For publicly traded firms in inefficient markets, where bondholders are protected: ¤ Maximize stockholder wealth: This will also maximize firm value, but might not maximize the stock price
¨ For publicly traded firms in inefficient markets, where bondholders are not fully protected ¤ Maximize firm value, though stockholder wealth and stock prices may not be maximized at the same point.
¨ For private firms, maximize stockholder wealth (if lenders are protected) or firm value (if they are not)